How China's Economy Works

From the WSJ:

Can China rebalance away from investment and toward domestic consumption as the main engine of growth? Yes, but with great difficulty. Chinese households consume only about 35% of gross domestic product (GDP), far less than any other country. Such a large domestic imbalance has no historical precedent.

Some in Beijing understand how lopsided their development has been. So over the next 10 years, policy makers have said they will try to raise consumption to 50% of GDP. Even that is a low number; it would put China at the bottom of the group of low-consuming East Asian countries.

But achieving this goal is problematic, since it requires that household consumption grow four percentage points faster than GDP. In the past decade, Chinese household consumption has grown by 7% to 8% annually, while GDP has grown at 10% to 11%. If one expects Chinese GDP to grow by 6% to 7%, Chinese household consumption would have to surge by 10% to 11%.

Such consumption growth is unlikely because powerful structural factors work against it. The Chinese growth model transfers income from households to the corporate sector, mainly in the form of artificially low interest rates. These sharply reduce borrowing costs for the state-owned companies that funnel this easy money into mega-investments. The easy financing also gooses banks' profit margins and allows them to resolve bad loans with ease.

This cheap borrowing comes at the expense of depositors. Low yields on deposits force them to sacrifice consumption, to save more. This results in a sharp decline in consumption's share of GDP. If China is to replace investment with consumption as the engine of growth, this process of financial repression has to be reversed. Households must get a rising share of overall growth.

This reversal is inevitable, but it will not come easily. Wasted investment and excess capacity translate into growing amounts of bank debt, meaning continued wealth transfers are necessary to keep the banking system viable. But if households continue to pay over the next few years, as they have in the past, China will be stuck in the same model.